Introduction

A pound of strawberries sells for $3 this week and $2.50 next week. A dollar exchanges for 100 Japanese yen one week and 102 Japanese yen the next week. Strawberries decrease in price when they are in season and the supply is greater. The dollar decreases in value when the demand for dollars relative to the yen decreases. In a free market system, currency values change the same way as conventional products like strawberries. Their prices are determined by supply and demand.

If a government keeps the value of its currency constant (fixed) relative to another country’s currency, it is similar to a government keeping the price of strawberries fixed for a period of time. Shortages occur when the price is set below the free market price, and surpluses occur when the price is set above the equilibrium. A freely fluctuating exchange rate system is more effective and economically efficient than a government-controlled, fixed-exchange-rate system. In a freely fluctuating exchange rate system, there are no long-run shortages and surpluses, and there is no need for central bank intervention. The first part of Unit 10 elaborates on these concepts.

The second part of Unit 10 describes the balance of payments. This is an estimate of the currency flows from and to other countries. The balance of payments consists of the current account, the financial account and the capital account. The current account includes all the day-to-day inflows and outflows of money: money exchanged for imported cars, computers, food, consulting services, tourism, securities investment earnings, and gifts. The financial and the capital accounts include the inflows and outflows of money involving purchases of financial investments, such as real estate, stocks, bonds, and foreign currency. Misconceptions about the trade deficit are discussed in this section, as well.